…all in the name of battling a pandemic, the world's most influential central bank has little/no room to manoeuvre when the next economic contraction takes place without the use of what could prove to be an extremely painful dose of monetary medicine.

A paper by Andrew Lilley and Kenneth Rogoff at the Harvard University Department of Economics is particularly pertinent in these novel times. The paper looks at the impact and changes that are necessary to implement an unconstrained negative interest rate policy as a solution to the near-zero effective lower bound and note that this scenario is likely to occur either during the next deep economic contraction or in the event of another financial crisis. While negative interest rates have been used in Europe and Japan, these rates have only been very mildly negative. What the authors are examining is the implementation of an unconstrained, deeply negative interest rate policy of at least two percentage points or more.

Here is an opening quote:

"Implementing effective negative rate policy will require a host of legal, regulatory and tax changes. A considerable amount of time and study is warranted, and the obstacles in different countries may vary. It is notable, however, that most of the changes were navigated fairly smoothly in countries that have implemented mild negative rate policy, albeit no country has tackled the main challenge, which is how to prevent paper currency hoarding and, as a corollary, how to protect bank profitability if rates go deeply negative. In this sense, the kind of unconstrained negative rate policy analyzed here is a very different animal from the very mild and highly-constrained negative rate policy that has been implemented to date." (my bold)

As the authors note, one of the key problems with a negative interest rate policy is hoarding of paper currency. We can think of it this way; if you invest your hard-earned money with a bank in a negative interest rate environment, you will get less money back once the investment matures. This will lead people to hoard paper currency since it will not lose value at least as it stands now. That said, one can imagine the amount of cash hoarding that could potentially take place by financial institutions, pension funds and insurance companies. It is this cash hoarding that could prove to be extremely problematic.

The authors have solutions to the "hoarding option" which is more likely to occur at interest rates lower than -2 percent:

1.) implementing a dual currency system where electronic currency becomes the unit of account which is pegged to the paper currency. By doing this, private banks will be able to pass on negative rates to larger-scale depositors and shield those retail depositors who have only small bank balances. This will have the added benefit of protecting bank profit margins and prevent a run on physical currency.

2.) phasing out large-denomination notes which the authors believe are generally used to fuel the underground economy. In this paper, the authors consider large denomination notes to be those that are $50 and above.

3.) taxing of cash would be required for rates lower than -2.5 percent to -3.0 percent. When interest rates are zero or positive, the exchange rate between electronic currency and paper currency is one to one. As interest rates drop into negative territory, central banks could adopt a policy where people turning in paper currency after 3 months will receive 99 cents worth of electronic currency, after six months receive 98 cents, after nine months receive 97 cents etcetera.

Another scheme for preventing cash hoarding is to use the serial numbers on paper currency in an expiry scheme. For instance, in one month, all notes ending with a "0" could be deemed valueless, the following month, all notes ending with "1" could be deemed valueless. This would force paper currency holders to redeem all of their inventory of bank notes before they became valueless.

The authors note that, while many would regard negative interest rates are an unfair tax on savers, they believe that negative interest rates make no greater impact on savings than inflation. As well, the authors also state that savers would benefit as negative interest rates boost the value of assets such as housing and stocks. To protect small savers, governments could allow citizens to register one account as eligible for zero interest rate protection.

While it may seem out of the realm of reality, the markets believe that there is a probability that negative interest rates will occur. In the New York Federal Reserve Bank's Survey of Market Participants dated March 2019, 11 percent of market participants believed that the target fed funds rate would be negative by the end of 2020 and 17 percent believed that there would be a negative target federal funds rate by the end of 2021 as shown here:

Let's close with this quote from the paper:

"Though many may disagree with our prescriptions, it is worth noting that even in the United States, both market pricing and survey data attribute material probabilities to nominal interest rates moving into negative territory in the near future – and yet they hold these beliefs without an agreed framework for how they would be implemented….

The biggest drawback to unconstrained negative rate policy is that it has not really been tried anywhere, and unintended consequences are possible. But in a deep finanial crisis, countries must often choose from a menu of difficult options, and after decade after the financial crisis, it is clear that none of the other options for restoring monetary policy effectiveness are particularly attractive or sustainable. As we have noted at the outset, the case for considering how to make unconstrained negative rate policy effective is stronger at present in Europe than the United States, and stronger still in Japan. In our view, it is quite likely that some advanced country central banks will experiment with unconstrained negative rate policy during a deep recession within the next decade. The United States is not the obvious first mover. However, given the steady downward drift in global real interest rates, the difficulties in raising expected inflation, the apparent ineffectiveness of quasi-fiscal instruments at the zero bound, and ultimately the importance to central bank independence of having an instrument that the Fed “owns”, creates a strong imperative for proactively preparing now for a negative interest rate world that is perhaps inevitable." (my bolds)

This research by Lilley and Roghoff flies in the face of the interest rate reality that most of us have dealt with our entire lives. Given that the authors believe that interest rate policies implemented by central banks are far more effective than other monetary policies like asset purchases (i.e. quantitative easing) and forward guidance, it is quite likely that central banks, particularly the Federal Reserve, will have no choice but to implement an unconstrained, deeply negative interest rate policy at some point in the future.

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